Analysis: Washington to Wall Street - Threat of default is real

WASHINGTON (Reuters) - Money lenders trust America so implicitly that they generally dismiss the risk it won’t pay its debts. But in the U.S. capital, fears are growing that political dysfunction might trigger the unthinkable.

The U.S. Capitol Building in Washington is pictured before sunrise September 16, 2013. REUTERS/Jason Reed

Government veterans from both political parties are aghast that lawmakers openly speak of managing a default that could be triggered next month if they don’t authorize more borrowing.

Another reason for concern is that the debate over the debt ceiling appears stuck on a Republican demand for big spending cuts in exchange for raising the $16.7 trillion borrowing limit.

This could be too tall an order because Washington is already slashing spending on almost everything but the welfare state. To go further, Congress would likely have to make cuts in sacrosanct programs like pensions and healthcare for the elderly, something lawmakers appear loath to do.

“The ingredients to put together a deal are diminishing,” said Tony Fratto of consultancy firm Hamilton Place Strategies, which advises investors on the workings of Washington. “Only the tough choices are there,” said Fratto, who was a spokesman at the White House and Treasury during the Bush administration.

Most discussion in Congress in recent days hasn’t even been focused on the debt ceiling. Rather, lawmakers are racing to approve legislation to keep most government offices running past this month when budgets are due to expire.

Now even the Treasury secretary, whose role usually includes telegraphing confidence to Wall Street, is expressing concern about the nation’s ability to keep paying the bills.

“I am nervous by the desire to drive this to the last minute,” Treasury Secretary Jack Lew told a business forum last week. Lew described himself as “anxious.”

And well he should be, said Steve Bell, an analyst at the Bipartisan Policy Center, which estimates the government will begin defaulting on its obligations between October 18 and November 5.

Bell, a Republican and a former staff director at the Senate Budget Committee, said he hasn’t worried this much about the prospect of default in his four decades in Washington.

THE ‘UNTHINKABLE’

A U.S. default would rock Wall Street and quite possibly trigger another economic crisis in a nation still struggling to recover from the 2007-09 recession. Borrowing costs could spike across the economy.

The last debt ceiling showdown in 2011 pushed the nation to within days of missing payments and led ratings firm Standard and Poor’s to strip Washington of its sterling credit rating.

That time around, Congress and the White House averted crisis by agreeing to deep spending cuts that were enacted this year but which largely spared so-called entitlement programs like Social Security pensions and Medicare insurance.

With the least difficult cuts already made, it could be much harder to reach a new budget-tightening deal before the nation runs out of cash. The White House has pledged not to even engage Republicans in a debate over the limit on borrowing.

“I feel less comfortable now than I did even in 2011,” Bell said.

Investors, however, still appear to be betting there is a smaller risk of default than the last time.

In the market for credit default swaps, which provide insurance against default, investors currently pay about $28,000 to insure $10 million in U.S. sovereign debt over the next five years. That’s up from a week ago, but still well below the peak of about $63,000 in July 2011.

On Tuesday, Lew said investor confidence that a debt limit deal will be struck is probably “greater than is should be,” Bloomberg reported.

Some investors are beginning to reassess the risks.

“Since irreconcilable differences are hardening. There is an increased likelihood that Congress and the president will not agree to raise the debt ceiling before time runs out,” Ray Dalio, founder of Bridgewater Associates, one of the world’s largest hedge funds, wrote in a report.

Lew’s expressed anxiety stands in contrast to the tone of his predecessor, Timothy Geithner, who steadfastly described default as “unthinkable” in 2011.

Now, many Republicans have supported a plan that would prioritize payments to creditors over other government obligations should the Treasury run out of money. The White House has said it would veto that plan.

Washington veterans say past generations of politicians would not even have entertained such a prospect so seriously.

That is allowing doubts to grow where investors previously had none. America is far from insolvent and, for generations, investors have bet there was no risk that America would fail to make good on its debts.

“The fact that it’s uncertain is the new element and the scary part,” said Alice Rivlin, a former head of the Congressional Budget Office and White House budget chief under President Bill Clinton.

She said she too has never seen the risk of default higher.

“A few years ago one would have said, ‘Don’t be silly. Of course they will raise the debt ceiling.’ But one can’t say that anymore.”